Here's why cutting the tax on dividends is a good idea: Corporate profits in the U.S. are taxed at progressive rates that rise to 35% for larger corporations. Profits distributed as dividends to shareholders are taxed again at the marginal income-tax rates appropriate to each recipient. Since retained earnings add to company wealth, they, too, are taxed again but at the much smaller tax rate on realized capital gains. Almost all other industrial nations provide full or partial tax relief from dividend taxation. Some allow tax credits for dividend income, while others tax dividends at lower rates than other income.
However, any short-run stimulus from eliminating the dividend tax would be too weak to have a significant benefit to the economy. In addition, the tax change would initially help higher-income families more than lower- and middle-class families, because ownership of equities and other capital is concentrated among richer families. This holds true even though direct or indirect ownership of equity over the past 20 years has spread to about half of all households, helped by the growing importance of individual retirement accounts, 401(k) plans, and other tax-deferred accounts.
Fortunately, the longer-run effects of eliminating the dividend tax on both the economy and the distribution of income are much more favorable. Evidence compiled by my University of Chicago colleague Casey Mulligan indicates that changes in taxes on capital have large effects on the capital stock over the long run. It turns out that real aftertax rates of return in the U.S. have hovered around 5% to 6% over the past half century, despite large changes in the effective tax rates paid on profits, incomes, and capital gains.
What happened was that as taxes on capital went up or down, aftertax returns adjusted through changes in the amount invested. For example, higher taxes on capital meant that investment declined and the capital stock grew more slowly; the process worked in reverse when taxes on capital decreased, as would happen should the tax on dividends be eliminated. Much of the adjustment in investment appears to have taken place within several years after taxes on capital were changed.
Since greater corporate investment in plant, machinery, and research and development boosts the long-term rate of economic growth, removing the dividend tax would stimulate expansion a few years hence. Yet there would be little impact on gross domestic product in the short run.
Greater investment and a higher capital stock also increase wages by raising the productivity of labor. Higher earnings lead more men and women to seek work, instead of looking to retire or stay out of the labor force. So in contrast to the short-term impact on income distribution, eliminating the dividend tax in the longer run would mainly benefit not the rich but lower- and middle-income families, because they receive most of their income from wages. In effect, the benefits of lower taxes on capital get shifted over time from owners of capital to suppliers of labor, as most of the historical evidence seems to show.
Eliminating the dividend tax would raise budget deficits significantly in the short run, but this change in tax policy would have a much smaller impact on deficits a few years down the road. The 1990s experience with surpluses and deficits at both federal and state levels showed that deficits tend to raise future government interest payments, but they also hold down future government spending in other areas. Surpluses have the opposite effect. Deficits created by lower tax rates may be the only effective way to curb the perpetual desire of politicians and interest groups to increase outlays on their favorite projects.
The double tax on dividends prompted companies over time to reduce their dividend payout ratios. These have fallen sharply during the past two decades. Most companies would not immediately change their dividend policy if this tax were removed, yet an increasing number over time would be forced by shareholder demand to shift toward larger dividends. In addition, higher payout rates would help monitor corporate governance by forcing management to reenter the capital market more frequently to finance investments and expansions.
The case for reducing taxes on capital is powerful, and eliminating the double tax on dividends is one way to do this. Removing that tax would, in the long run, raise the growth of capital, improve the productivity of labor, assist in monitoring corporate behavior, and help control government spending. Gary S. Becker, the 1992 Nobel laureate, teaches at the University of Chicago and is a Fellow of the Hoover Institution.